No. of Recommendations: 13
Gosh, that was a while ago.
A short summary: It works, but it's not something I do any more. I still add to positions on dips pretty often, but nothing formulaic.
The main slight modification I made first is that rather than holding the market position value steady, make it so the market value of your position doesn't rise any faster than some estimate of the actual value of the stock.
e.g., Imagine you own and are happy with the prospects of $100k worth of XYZ (both price and your estimate of value). The estimated value of a share of XYZ then rises by 10%. At that point there is certainly no problem owning $110k worth of XYZ. It is not so great if you own $100k worth of XYZ and the price doubles in that same stretch. You now own $200k market value of a stock, a block whose value you estimate to be only $110k. That's a risk. The constant-position-size strategy cuts that risk a lot, as you'd sell $90k worth, in stages, for a good profit. It would still be $90k of an overvalued position, but that's better than $200k worth of an overvalued position : )
This addresses the concerns of not letting your winners run. They get to run, but no faster than their value rises. All price rises beyond value rises are ultimately transient anyway.
The strategy does definitely have the problem of having to have the cash to do buy more. I tend to hold a fair bit of cash, so that's not a problem, but looking at the overall portfolio return you would probably do better using other methods because of the cash drag. You could instead rely on broker margin, but that way lies madness. (and being broke).
In the end, I just found it too much work for the size of the benefit.
What I later found works much better as a way of reducing your breakeven over time on a set of core positions, and as a general portfolio strategy, is writing repeated cash-backed puts. I found that it gives a return of around the midpoint between [the return on the underlying stock in the same period] and [10-12%/year]. It also lends itself to a bit of extremely low risk leverage, since you never need $100k to back up $100k worth of notional puts on different stocks at different prices expiring at different times. I don't think I've ever needed more than 30% of the cash pile, and even if you did need more than 100% of your cash it would just be a broker margin loan for a day till you sell the stock and replace it with fresh cash-backed puts. The main drawback is that sometimes premiums are very low. You can see that in advance before opening positions, so you just don't do it at those times--invest in some other way. The original inspiration came from Jeffrey Cohen's book "Put Options", though I modified the strategy a lot. Mainly I don't add hedging formulaically as he recommends, only smaller amounts at times that the market seems unsustainably high and premiums are low.
Writing puts isn't free money, but it's darned close, at least if you are able to estimate the value of a few stocks. Getting back to the thought of the constant position size strategy you asked about: Say you're firmly of the opinion that XYZ is worth a solid $100 a share, where it happens to be trading today. If you already know that you'd definitely be buying more XYZ if the price dropped to $80, why just wait for that to happen (which might or might not happen), when there are people out there offering to pay you cash in advance to commit to doing something you'd already decided to do? Say the premium on offer is $5, so your net cost would be $75 a share. Being forced to buy something at net $75 a share that you already valued at $100 is hardly a loss situation, no matter what the market price is that particular day.
The very best candidates are firms that are definitely not going bust, but have sold off a long way because of some worry, but you're convinced the worry is fatal. You don't have to believe that the price will rebound any time soon. Such stocks can stay at low prices and high option premiums for years at a time, and you can make 15-20%/year from a flat stock price. They're often seen as duds, so you don't want to admit to your friends what you're long! I've even made good money on stocks that ultimately DID blow up in some way, but so slowly that I was making money faster than they were sliding. I made IRR 31%/year on USG before leverage on the portfolio, and 28%/year on Sears.
Jim
